Fraud is a concern in almost any industry, but the area of construction seems to be particularly susceptible to this malady. As a fairly recent study has shown, the amount... Read More
The Basics of Reallocations and Change Orders
Construction projects are complicated endeavors with numerous participants and processes. This is why it is nearly impossible to predict the exact amount of costs involved. Regardless of the amount of time and attention dedicated to budget planning, no matter how big or small your construction project, you will likely deviate from the initial plan. Chances are that, somewhere down the line, some things will need to be modified. That’s where change orders and reallocations come in.
A change order is a term used for an amendment to the original construction contract. It addresses any changes outside of the scope of the contract that arise during the construction process, whether they are changes in the scope of work, materials costs, or contract terms.
Change orders don’t necessarily arise from poor budgeting and planning, or any errors made during the construction process, even though this is often the case. They are sometimes caused by events outside of the control of any of the involved parties, which can vary from market conditions and labor costs to weather conditions and other unforeseen circumstances. Change orders don’t even necessarily carry additional costs – sometimes they even reduce costs, if the changes in question require less work, fewer materials or materials of lesser value.
As change orders generally bring about additional costs, they are usually heavily negotiated between the lender and the borrower. It is in the lender’s interest that the construction costs are covered by the loaned funds and, before any additional funding is approved, the lender and the borrower will first look to see whether any funds can be shifted between different line items in the project. This process is called reallocation.
Reallocation is the transfer of project funds from one line item to the other. Since change orders are so common, loan agreements often include contingency funds in the budget designed to address change order scenarios. In case of a change order, the funds will then be reallocated from the contingency funds to the line item(s) defined by the change order. Ideally, these funds will be sufficient to cover the additional costs of change orders.
Negotiating the terms of reallocation is one of the touchiest aspects of the loan agreement. Naturally, the loanee will wish for more flexibility in the use of contingency funds, while the lender will wish to maintain a great degree of control over how the funds are used. In order to ensure that the contingency funds are not exhausted before the project is completed, the lender will sometimes tie the amount of contingency funds approved for a change order to the project’s completion percentage. In other words, the lender will only approve the percentage of the contingency funds equal to the percentage of completed work.
It is in the best interest of all involved parties that a loan agreement is comprehensive and meticulous in its realistic assessment of the project’s total budget, including the anticipation of changes to the project and detailed mechanisms for addressing these changes.
How to Reduce Change Orders
We have already determined that change orders are almost inevitable, but there are steps that can be taken in order to minimize the number of changes necessary for the project’s completion. It all comes down to being meticulous in considering all predictable aspects of the project.
A realistic assessment of the project’s total cost should be performed and should not only include the construction work, but also all accompanying costs (safety measures, material storage, insurances, taxes, etc.) The project location and its natural suitability for the project should also be under intense scrutiny in order to avoid any potential problems further down the road. The same goes for contractor bids and ensuring that you know the exact amount and quality of work you will get for the price before you make a choice.
You should also ensure a clear line of communication between all involved parties. Mistakes often arise from misunderstandings and lack of complete information, and it is essential for the project’s success that everyone is on the same page. Construction loan management software like Contract Simply can help with this.